Manager's strategy includes converts, debt-equity swaps

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SAN FRANCISCO (CBS.MW) -- One fund manager sees high-yield corporate bonds, debt-for-equity swaps and other convertible securities as the mainstay of a portfolio that will weather rocky spans.

Anthony Gambacorta has long backed the notion of an all-weather portfolio for investors who prefer to use a variety of asset classes to reduce the earth-shaking gyrations of day-to-day financial markets.

Of note is the fact that the chief investment officer of $150 million Preswick Capital Management in Pennsylvania was an early believer in high-yield bonds and other fixed-income investments, such as convertible securities. These soared in value this year as investors seek decent yields and capital appreciation on their holdings. See:To junk or not to junk?

It wasn't an entirely smooth path for Gambacorta. The fund manager in late 2001 had to endure a 10 percent or so loss for his all-weather portfolio in the wake of the Sept. 11 terrorism that year. Gambacorta's all-weather portfolio, designed to take hard knocks from the economy, moved to avoid international and small stocks, sell bonds and hoard cash.

The strategy allowed him, the following year, to sweep back into mutual funds that favored junk bonds and other high-yielding securities at incredibly cheap prices. Junk bonds and other low-grade corporate bonds, along with convertible securities and anything that allowed companies to swap debt for equity, then staged an enormous rally as interest rates sank to historic lows through late June of this year.

Gambacorta still sees high-yielding corporate bonds, and the mutual funds that specialize in them, as good bets in an uncertain market environment.

"Buy and hold stock-market investors will not be well rewarded," he says. "During this three-year bear market in stocks, there have been three significant trading opportunities from intermediate-term bottoms. Unless the current move confirms a new bull market by moving to new highs, we may be near the top of another bear market rally."

Gambacorta believes corporate bond holders will benefit from executives who have pledged to improve their balance sheets and excise the financial shenanigans of the past.

"CEOs must now focus on balance sheet strength, paying dividends and increasing the transparency on their financial statements," he says. "This will lead to lower returns for corporate equities and higher returns for corporate bonds for the next several years, as the pendulum swings back toward conservative financial measures."

To be sure, many mutual funds that specialize in high-yield corporate debt, such as Fidelity Advisor High Income Advantage Fund Class C
FAHEX,
+1.60%,
have had a rally of 25 percent or more since their low points of October 2002, thanks to prospects for an improved U.S. economy and an increased appetite for risk. (For moreon how to profit from the risk for appetite, see The Calandra Report.)

"But I think we are only in the third or fourth inning with these bonds that have growth kickers," he says. "Go to the bankruptcy courts and you see companies picking up assets at four times cash flow, pretty cheap."

Gambacorta, speaking to me from his Media, Penn., office, says MCI
WCOM,
+0.30%,
the telephone company that's part of the ravaged WorldCom group, is a good example of an operation that eventually will emerge with no debt, "and it is the corporate bond holders that will have the new equity," he says.

Many mutual funds in this area have hundreds of such holdings, "so they are relatively well protected from damage by one specific situation," he says.

The recycling of debt to equity for bondholders in this risky sector is just beginning, says Gambacorta. "Right now, the high-yield funds in particular are just getting the equity they swapped for in their bankruptcy proceedings. Twelve to 18 months from now, the equity in formerly bankrupt companies may be re-offered to the public, with clean balance sheets, and let the funds cash out.

Another holding is the Pioneer High Yield Fund Class C
PYICX,
+1.22%,
which specializes in so-called "busted convertibles," a class of bonds that could allow holders access to very cheap converted equity in troubled companies. "Don't let the name fool you, this fund has over 60 percent of its assets in convertibles, with the balance allocated to high-yield bonds," says Gambacorta.

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